Transcript 8/1 - Pearson Canada

Chapter 8
The Theory of Perfect
Competition
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A Competitive Model of exchange
 In
an exchange economy, goods are
exchanged but not produced.
 Reservation price is the maximum
amount a person is willing to pay for a
good.
 Market demand & market supply
functions give the total number of units
demanded & supplied at a given price.
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Figure 8.1 Demand and supply
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From Figure 8.1
 All
individuals supply/demand only
one unit of the good and their
individual demand/supply curves are
given by their reservation willingness
to pay for a good.
 The decision to be “in” or “out” of the
market is called the extensive
margin.
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Figure 8.2 Competitive equilibrium
in an exchange economy
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From Figure 8.2
 Imagine
there is a Walrasian
auctioneer who acts as a price setter.
 If quantity demanded/supplied at the
announced price exceeds quantity
supplied/demanded there is excess
demand/supply.
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From Figure 8.2
 The
auction ends in a competitive
equilibrium only when quantity
demanded equals quantity supplied.
 This competitive allocation is Paretooptimal or efficient.
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The Function of Price
 In
a market economy, prices are the
signal that guide and direct
allocation.
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The Assumptions of Perfect Competition
1.
Large Numbers: No individual demander or
2.
Perfect Information: All participants have perfect
3.
Product Homogeneity: In any given market, all
4.
Perfect Mobility of Resources (Inputs).
Independence: Individual consumption and
5.
supplier produces a significant proportion of the total
output.
knowledge of all relevant prices and technology.
firms’ products are identical.
production decisions are independent of all other
consumption/production decisions.
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Firm’s Short-run Supply Decision
A
firm’s profit (π) is its total revenue
(TR) minus short-run total costs (STC).
 The profit function is expressed as:
π(y) = TR(y)-STC(y)
 Profit is maximized at y*, as a function
of the exogenous variable price (p).
 The slope of the profit function with
respect to output is zero at y*.
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Figure 8.4 Profit maximization
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Marginal Revenue and Marginal Cost
 The
slope of the total revenue
function is marginal revenue (MR).
 The slope of the total cost function is
marginal cost (MC).
 The firm will maximize profits by
equating MR & MC:
 SMC(y*)=MR=p
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Figure 8.5 The competitive firm’s supply function
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From Figure 8.5

1.
2.
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Short-run profit maximization
requires SMC(y*)=MR=p, subject to
two qualifications:
SMC is rising.
p>minimum value of AVC.
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Profit Maximization
 Profit
can be expressed as:
π(y*) = y*[p-SAC(y)]
Where: p-SAC(y) is profit per unit of y
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Figure 8.6 The profit rectangle
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Figure 8.7 Aggregating demand
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Figure 8.8 Aggregating supply
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Figure 8.9 Short-run competitive equilibrium
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Efficiency of the Short-Run
Competitive Equilibrium
 The
short-run equilibrium shown in Figure
8.9 is considered to be efficient because
it maximizes consumer surplus and
producer surplus.
 The sum of consumer surplus and
producer surplus, known as total
surplus, is a measure of the aggregate
gains from trade realized in this market.
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Long-Run Competitive Equilibrium

1.
2.
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There are two conditions of longrun equilibrium:
No established firm wants to exit
the industry.
No potential firm wants to enter the
industry.
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Long-Run Competitive Equilibrium



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Positive profit is a signal that induces
entry, or allocation of additional
resources to the industry.
Losses are a signal that induces exit, or
the allocation of fewer resources to the
industry.
In long-run equilibrium, price equals the
minimum average cost which is the
efficient scale of production.
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Figure 8.10 Exit, entry, and
long-run competitive equilibrium
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Figure 8.11 The firm in long-run
competitive equilibrium
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Long-Run Supply Function
 The
long-run competitive equilibrium is
determined by the intersection of LRS
and the demand function.
 Deriving LRS incorporates changes in
input prices that arise as industry-wide
output expands.
 These changes determine whether the
industry is a constant, increasing, or
decreasing cost industry.
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Figure 8.12 LRS in the constant-cost case
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Figure 8.13 LRS in the increasing-cost case
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